Can a Roth IRA Be Used as Collateral?
Internal Revenue Service rules are very clear: you cannot use your Roth Individual Retirement Account as collateral on a loan. Should you do so, the portion of the account you put up as collateral is considered a distribution, in which case it ceases to be a Roth IRA asset.
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Prohibited Transactions
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Using your Roth IRA as collateral on a loan is on the IRS' list of prohibited transactions -- activities you must not engage in if your IRA is to remain an IRA. Prohibited transactions also include borrowing money from your IRA or selling goods and services to it. You can't use your IRA to purchase something for your own use; for example, if you purchase a vacation property with IRA funds, you can rent it out, but never stay there yourself. Finally, you cannot pay yourself an inordinate amount of money to manage an asset your IRA owns.
Disqualified Persons
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Prohibited transactions apply not only to you, but to what the IRS calls "disqualified persons," as well. Your descendants (children and grandchildren), your ancestors (parents and grandparents) and their spouses are disqualified. Fiduciaries are also barred from making prohibited transactions. Fiduciaries are people responsible for managing your IRA or advising you on how to manage it. They also include parties who are involved with administering your account, i.e., buying and selling assets and collecting asset earnings.
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Tax Consequences
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The moment you pledge all or a portion of your Roth IRA as collateral, the IRS says you have taken a distribution from your account. If your account has been open at least five years and you are 59 1/2, you do not owe taxes on the amount; however, you miss out on possible tax-free earnings that portion of your distribution may have earned. If you are not yet 59 1/2, or you are but your account has not yet been open five years, you owe a 10 percent penalty on amounts you withdraw that exceed your total Roth IRA contributions.
Significance
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Prohibited transactions are intended to prevent you from benefiting twice from your IRA. Your Roth IRA provides you with a powerful tax incentive to save for retirement: you can accumulate tax-free earnings on your investments that are available to you beginning the year you turn 59 1/2. In the meantime, the IRS does not want you to use your tax-sheltered assets to enrich yourself or your family. Furthermore, putting your Roth IRA up for collateral would mean risking retirement income, which the government does not want to encourage.
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